l2 flash cards fixed income - ss 14

Study Session 14, Reading 42

Default Risk, Credit Spread Risk, and Downgrade Risk

default risk - the risk that the borrower will not repay the obligation

credit spread risk - the risk that the credit spread will increase and cause the value of the issue to decrease and/or cause the bond to underperform its benchmark.

downgrade risk - the risk that the issue will be downgraded by the credit rating agencies, which will also cause the bond price to fall, and/or cause the bond to underperform its benchmark.


Sources of information to asses the default risk of a bond

1. Credit Rating2. Rating Watch 3. Rating Outlook


Four Cs of credit analysis1. Character - management’s integrity and commitment to meet obligations2. Covenants - the terms and conditions, the borrowing and lending parties

have agreed to as part of the bond issueTwo types of Covenants

i. Affirmative covenants ii. Negative covenants

3. Collateral - the assets offered as security for the debt as well as other assets controlled by the issuer

4. Capacity - to the corporate borrower’s ability to generate cash flow or liquidate short-term assets to repay its debt obligations.


Factors to Evaluate the Capacity to Pay

Industry trendsRegulatory environmentOperating and competitive positionFinancial position and sources of liquidityCompany structureParent company support agreementsSpecial event risk


Factors to Evaluate the financial position and sources of liquidity

Working capital position of the firmDependable cash flowBack up facilitiesSecuritized assetsThird party guarantees


Credit Analysis with RatiosSolvency Ratios

Current Ratio = Current Assets / Current Liabilities Acid Test Ratio = (Current Assets – Inventories) / Current Liabilities

Capitalization or Financial Leverage Ratios Long term debt to capitalization ratios = Long term debt / (Long term debt +

Minority Interest + Shareholders common and preferred equity ) Total debt to capitalization ratios = (Current Liabilities + Long term debt) /

(Current Liabilities + Long term debt + Minority Interest + Shareholders common and preferred equity)


Credit Analysis with Ratios (cont.)Coverage RatiosEBIT Coverage Ratio = EBIT / Annual Interest Expense

EBITDA Coverage Ratio = EBITDA / Annual Interest Expense

Du Pont Analysis ROE = Net Income / Shareholders equity = ( Net Income / Sales) *

(Sales/Total Assets) * (Total assets / Shareholders equity)

Cash Flow Measures Used by S&PFunds from operations = Net Income + Depreciation +/- other non

cash itemsOperating cash flow = Funds from operations + decrease (increase)

in non current assets – increase (decrease) in non current liabilitiesFree operating cash flows = Operating cash flow – capital

expendituresDiscretionary cash flows = Free operating cash flow – cash dividendsPre-financing cash flows = Discretionary cash flows – acquisitions +

asset disposals + other sources


Ratios Used by S&PCoverage Ratios (the higher the ratio, the stronger the issuer’s

capacity to pay): Funds from operations / total debt Funds from operations / capital spending requirement (Free operating cash flow + Interest) / Interest (Free operating cash flow + Interest) / ( Interest + Annual Principal

Repayment)Leverage Ratio ( the lower the ratio, the stronger is the issuer’s

capacity to pay)Debt Payback Period = Total debt / Discretionary cash flows


Two Areas to Analyse High-Yield Issuers

Debt Structure Analysis - includes the following types of issues: bank debt, reset notes, and senior and subordinated debt (which may be zero coupon bonds).

Corporate Structure Analysis - Debt is borrowed at the parent level, and funds to pay the obligation in the future are obtained from operating subsidiaries


Credit Analysis of Asset Backed Securities

Collateral Credit Quality - Rating agencies evaluate whether the collateral is of sufficient quality to be able to provide cash flows to pay principal and interest over the life of the issue

Seller/ Servicer Quality - Rating agency looks at the servicer’s performance history, experience, underwriting standards adopted for loan originations, servicing capabilities (including databases, systems, and personnel), financial strength, and growth relative to its competitive and business environment.


Credit Analysis of Asset Backed Securities (cont.)

Cash Flow Stress and Payment Structure - Rating agencies analyses cash flow projections under different scenarios related to losses, delinquencies, and economic conditions to assess how these cash flows are distributed to the various tranches (bonds) in the asset-backed security structure.

Legal Structure - A firm that securitizes assets, , in the event of bankruptcy, the courts will not apply the cash flow from the collateral toward satisfaction of general corporate liabilities


Risk Considerations for Tax Backed Debt

Issuer’s debt structureBudgetary policyLocal tax and intergovernmental revenue availabilityIssuer’s socioeconomic environment


Risk Considerations for Revenue Bonds

Limits of the basic securityFlow of funds structureRate, or user charge, covenantPriority-of-revenue claimsAdditional Bonds Test


Economic risk factors in evaluation of Sovereign Ratings

Economic and income structureProspects for economic growthDegree of fiscal flexibilityPublic debt burdenMonetary policy and price stabilityBalance of payments flexibilityExternal debt and liquidity


Political risk factors in evaluating Sovereign Ratings

Form of government and degree of citizen participation in the political process.

Political stability and orderliness of leadership or political party succession.

Degree of national agreement on economic policy goals.Integration of its economy in global trade and financial

systems.Internal and external security risks.


Local Currency Ratings and Foreign Currency Debt Ratings

Factors used in analysis of local currency debt ratings: political stability and the extent of participation by the populace in the political process income base and growth along with economic infrastructure tax discipline and budgetary record monetary policy and the rate of inflation the government debt burden and debt service experience

Factors used in the analysis of foreign currency debt ratings: country’s balance of payments the composition of external balance sheet relative to its external debt (foreign currency)

obligations.


Multiple Discriminate Analysis (MDA)Multiple Discriminate Analysis (MDA) - a statistical technique used to predict default.

Z Score Model - one type of MDAZ =1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Where:X1 = Working capital/Total assets (in decimal)X2 = Retained earnings/Total assets (in decimal)X3 = Earnings before interest and taxes/Total assets (in decimal)X4 = Market value of equity/Total liabilities (in decimal)X5 = Sales/Total assets (number of times)Z = Z-score


Credit Risk ModelsStructural Models - based on option pricing theory((Brian

Scholes Option Pricing Model)

Reduced Form Models - do not look “inside the firm,” but instead model directly the probability of default or downgradePopular Models:

Jarrow and Turnbull Model Duffie and Singleton Model


Three Types of Yield Curves1. normal or positively sloped yield curve –the most common

relationship are yields in which the longer the maturity, the higher the yield

2. flat yield curve - the yield for all maturities is approximately equal.3. inverted or a negatively sloped yield curve - the relationship

between maturities and yields was such that the longer the maturity the lower the yield

steepness or slope of the yield curve - The difference between long-term Treasury yields and short-term Treasury yields


Parallel and Non Parallel Shifts in the Yield Curve

shift in the yield curve - the relative change in the yield for each Treasury maturity

parallel shift in the yield curve - a shift in which the change in the yield for all maturities is the same

nonparallel shift in the yield curve - the yield for different

maturities does not change by the same number of basis points


Types of Non Parallel Shifts

1. A downward shift in the yield curve combined with a steepening of the yield curve.

2. An upward shift in the yield curve combined with a flattening of the yield curve.

twist in the slope of the yield curve - a flattening or steepening of the yield curve

butterfly shifts - nonparallel shifts in the yield curve that change its curvature


Construction of Spot Rate Curve

shift in the yield curve - the relative change in the yield for each Treasury maturity

Selection of SecuritiesDetermine the methodology for constructing the curve bootstrapping is used as a repetitive technique


Selection of SecuritiesYields should not be biased on the following:1. Default2. Embedded options3. Liquidity4. Pricing errors

Treasury issues that are candidates for inclusion 1. Treasury coupon strips2. On the run Treasury issues3. On the run Treasury issues and selected off the run issues4. All Treasury coupon securities and bills


Elements of Swaps and Swap CurveTwo parties “swapping” payments One party is paying a floating rate and receiving a fixed rate, and The other party is paying a fixed rate and receiving a floating rate.

Swap is described in terms of a “rate”.The most common reference rate used in swaps is the 3-month

LIBOR. When LIBOR is the reference rate, the swap is referred to as a “LIBOR- based swap”.


Swap SpreadSwap spread reflects the risk of the counterparty to the swap

failing to satisfy its obligation.Swap spread primarily reflects credit risk.

Value: Swap spread = Swap rate - Government yield on a bond with the same

maturity as the swap


Pure Expectations Theorypure expectations theory - forward rates exclusively represent expected

future spot rates

The theory neglects the risks inherent in investing in bonds. Two types of risks in bond investments:

1. interest rate risk 2. reinvestment risk


Liquidity Preference Theory, Preferred Habitat Theory

Liquidity Preference Theory - the investors will hold longer-term maturities if they are offered a long-term rate higher than the average of expected future rates by a risk premium that is positively related to the term to maturity

Preferred Habitat Theory - rejects the assertion that the risk premium must rise uniformly with maturity


Measuring Yield Curve Riskyield curve risk - the exposure of a portfolio or position to a change in the term

structure

Yield curve risk can be measured by changing the spot rate for a particular key maturity and determining the sensitivity of a security or portfolio to this change, holding the spot rate for the other key maturities constant.


Measuring Historical Yield Volatilityyield volatility – Parameter measured the exposure of a portfolio to rate changes

depends on how likely and how much interest rates may change

Formula:Xt = 100[Ln(yt/yt- 1)]


Annualizing the Standard DeviationFormula:

Daily standard deviation * sqrt (number of days in a year)

Some investors and traders use the number of days in the year, 365 days, to annualize the daily standard deviation. Some investors and traders use only either 250 days or 260 days to annualize.


ARCH Modelautoregressive conditional heteroskedasticity (ARCH) model - The statistical model used to estimate

this time series property of volatility conditional - the value of the variance depends on or is conditional on the value of the random

variable

heteroskedasticity - the variance is not equal for all values of the random variable


Determination of benchmark interest rates

The Treasury marketA sector of the bond marketThe market for issuers securities


Generation of Interest Rate Trees

The interest rates on the tree are used to generate the cash flows taking into account the embedded option.

The interest rates on the tree are used to compute the present value of the cash flows.


Binomial Model, Trinomial Model, Discrete Time Option Pricing Model

interest rate model - a probabilistic description of how interest rates can change over the life of the bond

Interest Rate Tree Models:binomial model - valuation model that assume that interest rates can realize one of two possible rates in the next periodtrinomial models - valuation model that assume that interest rates can take on three possible rates in the next perioddiscrete time option pricing model – a more complex model that assume in creating an interest rate tree that more than three possible

rates in the next period can be realized


Benchmark interest rates Benchmark interest rates can be one of the following:

The Treasury market A specific bond sector with a given credit rating A specific issuer

Benchmark interest rates can be based on either: An estimated yield curve An estimated spot rate curve

Thus there are six potential benchmark interest rates (2*3).


Spread Measuresnominal spread – a spread measured relative to the Treasury yield curve and reflects compensation for credit risk, liquidity risk and

option risk zero volatility spread – a spread relative to the Treasury spot rate curve and reflects compensation for credit risk, liquidity risk and

option risk option adjusted spread - a spread relative to the Treasury spot rate curve and reflects compensation for credit risk and liquidity risk.


OAS, Benchmark and Relative ValueWhen the benchmark is the Treasury spot rate curve:

the security is expensive if the security OAS is greater than required OAS the security is cheap if the security OAS is less than required OAS if the security OAS is equal to the required OAS, the security is fairly priced

When a sector of the bond market with the same credit rating is the benchmark:

if the security OAS is greater than the required OAS, the security is cheap if the security OAS is less than the required OAS, the security is expensive if the security OAS is equal to the required OAS, the security is fairly priced


Backward Induction MethodologyIt is a discounting process for valuing bonds with a binomial interest rate tree. It refers to the process of discounting distant values in a binomial tree, one node at a time,

backwards through time to generate a current value.


Valuation of Callable Bonds and Putable Bonds using Binomial Model

Callable bonds can be valued by modifying the cash flows at each node in the interest rate tree to reflect the cash flow prescribed by the embedded call option according to the call rule.

Putable bonds are valued using the same procedure as for a callable bond, except that the relevant cash flows are dictated by the rules governing the exercise of the embedded put option.


Valuation of Bond with Embedded Options and Floating Rate Notes using Binomial Model

bond with an embedded option or options - can be valued by requiring that the value at each node of the tree be adjusted based on whether or not the option will be exercised

floating-rate note - the binomial method must be adjusted to account for the fact that a floater pays in arrears. That is, the coupon payment is determined in a period but not paid until the next period.


Convertible Securities

The owner can exchange the bond for the common shares of the issuer.Gives the bondholder the right to buy the common stock of the issuer.Almost all convertible bonds are callable, and some convertible issues are putable.


Conversion Price, Conversion Ratioand Straight Value

conversion ratio - number of common shares for which a convertible bond can be exchanged.conversion price - issue price divided by the conversion ratio.conversion value - value of the stock into which the bond can be converted.

conversion value = market price of stock × conversion ratio straight value - value of the bond if it were not convertible market conversion price - price that a convertible bondholder would effectively pay if the bond were purchased and immediately converted.

market conversion price = market price of convertible bond/conversion ratio


Fixed Income, Common Stock and Hybrid Equivalents

fixed income equivalent (or a busted convertible) - the straight value is considerably higher than the conversion value so that the security will trade much like a straight security.

common stock equivalent - the conversion value is considerably higher than the straight value so that the convertible security

trades as if it were an equity instrument. hybrid equivalent - the convertible security trades with characteristics of both a fixed income security and a common stock

instrument.


Advantages and Disadvantages of Convertibles

Advantages:reduction in downside riskthe price appreciation resulting from an increase in the value of the common stock

Disadvantages:the upside potential given-up because a premium per share must be paidwhen the stock price rises, the bond will underperform because of the conversion premium of the bond


Mortgages

mortgage - a loan secured by the collateral of some specified real estate property which obliges the borrower to make a predetermined series of payments

the mortgage rate or contract rate - interest rate on the mortgage loan


Types of Mortgage Designsmortgage design - a specification of the interest rate, term of the mortgage, and the manner in which the borrowed funds

are repaid

Types of Mortgage Designs: fixed-rate, level-payment fully amortized mortgages adjustable-rate mortgages balloon mortgages growing equity mortgages reverse mortgages tiered payment mortgages


Types of Mortgage Backed Securities1. residential mortgage-backed securities - backed by residential mortgage loans Sectors: agency mortgage backed securities - issued by federal agencies non agency mortgage-backed securities - issued by private entities

Residential mortgage-backed securities include: mortgage passthrough securities collateralized mortgage obligations stripped mortgage-backed securities.

2. commercial mortgage-backed securities - backed by commercial loans


Residential Mortgage DesignMost common mortgage design in the United States: fixed-rate mortgage level-payment mortgage fully amortized mortgage.

Features:the mortgage rate is fixed for the life of the mortgage loanthe dollar amount of each monthly payment is the same for the life of the mortgage loan when the last scheduled monthly mortgage payment is made, the remaining mortgage balance is zero


Residential Mortgage Servicing Feeservicing fee - a portion of the mortgage rate

Servicing of a mortgage loan involves: collecting monthly payments and forwarding proceeds to owners of the loan sending payment notices to mortgagors reminding mortgagors when payments are overdue maintaining records of principal balances initiating foreclosure proceedings if necessary furnishing tax information to borrowers (i.e. mortgagors) when applicable.


Residential Mortgage Prepayment

prepayment - a payment made in excess of the monthly mortgage paymentcurtailment - When a prepayment is not for the entire outstanding balanceprepayment risk - the risk when amount and timing of the cash flow from a mortgage loan are not

known with certaintylockout period or penalty period - a period of time over which if the loan is prepaid in full or in excess of

a certain amount of the outstanding balance, there is a prepayment penalty


Types of Mortgage Passthrough Securities

mortgage passthrough security - created when one or more holders of mortgages form a collection (pool) of mortgages and sell shares or participation certificates in the pool.

Types:1. agency mortgage pass through securities – backed by an agency securityUnderwriting Standards: conforming mortgage nonconforming mortgage

2. non agency mortgage pass through securities - are nonconforming mortgages used as collateral for mortgage pass-through securities and are privately issued


Weighted Average Coupon and Weighted Average Maturityof Mortgage Passthrough Securities

weighted average coupon rate(WAC) - found by weighting the mortgage rate of each mortgage loan in the pool by the percentage of the mortgage outstanding relative to the outstanding amount of all the mortgages in the pool.

weighted average maturity(WAM) - found by weighting the remaining number of months to

maturity for each mortgage loan in the pool by the amount of the outstanding mortgage balance.


Measuring the Prepayment Ratesof Mortgage Passthrough Securities

single monthly mortality rate(SMM) - ratio of the prepayment in a month and the amount available to prepay that month

Formula:SMM = (Prepayment in month) / (Beginning mortgage balance for month t – Scheduled Principal

Payment in month t)

Formula: Given an assumed SMM for month t:(Prepayment in month) = SMM * (Beginning mortgage balance for month t – Scheduled Principal

Payment in month t)


Conditional Prepayment Rate (CPR)of Mortgage Passthrough Securities

Formula: Given the SMM for a given month

CPR = 1 - (1 - SMM)12

Formula: Given a CPRSMM = 1 – (CPR)1/12


PSA Prepayment Benchmark Expressed as a monthly series of CPRs. It assumes that prepayment rates are low for newly originated mortgages and then will speed up as the mortgages

become seasoned. It assumes the following prepayment rates for 30-year mortgages a CPR of 0.2% for the first month, increased by 0.2% per year per month for the next 30 months until it reaches 6% per year, and a 6% CPR for the remaining months.

Mathematically, 100 PSA can be expressed as follows: if t < 30 then CPR = 6% (t/30) if t > 30 then CPR = 6%


Average Life of Mortgage Passthrough Securities

weighted average life or average life - measure widely used by market participants

Formula:Average Life = ∑ (t * Projected Principal received at time t) / (12 *

Total Principal)


Factors affecting Prepayment BehaviourPrevailing mortgage rateHousing turnoverCharacteristics of the underlying residential mortgage loans


Contraction and Extension Risk of Mortgage Passthrough Securities

contraction risk - undesirable consequences of declining interest rates: MBS exhibit negative convexity cash flows must be reinvested at a lower rate.

extension risk - the drop in bond prices and the slowing of prepayments as interest rates increase


Collateralized Mortgage Obligations (CMOs)

Collateralized mortgage obligations are bond classes created by redirecting the interest and principal from a pool of pass throughs or whole loans.

CMOs are securities issued against a pool of mortgages for which the cash flows have been allocated to different classes called tranches.


Design of CMOs

Sequential-pay tranches - a common arrangement for separating mortgage cash flows into classes to create CMOs where each class of bond is retired sequentially.

Planned Amortization Class (PAC) tranches - the most common type of CMO, have a payment schedule that is established within a range of prepayment speeds called the initial PAC collar.


Stripped Mortgage Backed Securitystripped mortgage-backed security - a derivative mortgage-backed security that is created by

redistributing the interest and principal payments to two different classes.

Classes:principal-only mortgage strip (PO) - a class of securities that receive only the principal payment

portion of each mortgage payment. The PO exhibits some negative convexity at low rates. interest-only mortgage strip (IO) – a classes that receive only the interest component of each

payment. The IO price is positively related to mortgage rates at low current rates.


Non Agency Residential Mortgage Backed Security

non agency MBS (non agency securities) - issued by private entities and are usually backed with nonconforming mortgage loans

nonconforming mortgage - loans that fail to meet the agency’s underwriting standards

Non agency security cash flows are affected by mortgage default rates and thus require credit enhancement


Commercial Mortgage Backed Security

commercial mortgage-backed securities - backed by a pool of commercial mortgage loans—loans on income-producing property.

Features: structured as nonrecourse loans on two key ratios to assess the credit risk

Debt-to-service coverage ratioLoan-to-value ratio.


Call Protection for CMBS

Degree of call protection available investor: At the loan level From the actual CMBS structure.

Methods of call protection at the loan level includes: Prepayment lock outs Defeasance Penalty fees Yield maintenance charges


Parties in a Securitization Process

Seller - originates the loans and sells them to the issuer/trust.Issuer/trust - buys the loans from the seller and issues the ABS.Servicer - who services the original loans.


Home Equity LoansClosed-end Home Equity Loans (HELs) - secondary mortgages that are structured just

like a standard fixed rate, fully amortizing mortgage.Distinctive Feature: credit traits of the borrowers

Structure:non-accelerating senior tranches planned amortization class (PAC) tranches.


Manufactured Housing Backed Securities

manufactured housing asset backed securities - backed by loans for manufactured homes.

Distinctive feature: relatively stable prepayments


Auto Loan Backed SecuritiesAuto loan-backed securities - backed by loans for automobiles

Distinctive Features: Prepayments are caused by sales and trade-ins, the repossession/resale process, insurance payoffs due to thefts and accidents, borrower payoffs, and refinancing.

Auto loans have 36- to 72-month maturities and are issued by the financial subsidiaries of auto manufacturers, commercial banks, credit unions, etc.


l2 flash cards fixed income - ss 14

Documents

cash flow stress

cash flow measures

debt obligations

bank debt

subordinated debt

long term debt longterm

firm dependable cash

credit spread risk